Volume 33 Issue 3 Article 2
2006
There Are No Penalty Default Rules in Contract Law
There Are No Penalty Default Rules in Contract Law
Eric A. Posner [email protected]
Follow this and additional works at: https://ir.law.fsu.edu/lr
Part of the Law Commons
Recommended Citation Recommended Citation
Eric A. Posner, There Are No Penalty Default Rules in Contract Law, 33 Fla. St. U. L. Rev. (2006) . https://ir.law.fsu.edu/lr/vol33/iss3/2
F
LORIDA
S
TATE
U
NIVERSITY
L
AW
R
EVIEW
T
HERE
A
RE
N
O
P
ENALTY
D
EFAULT
R
ULES IN
C
ONTRACT
L
AW
Eric Posner
V
OLUME
33
S
PRING
2006
N
UMBER
3
ERIC A.POSNER*
ABSTRACT
In an influential article, Ian Ayres and Robert Gertner introduced the concept of the “penalty default rule,” a rule that fills a gap in an incom-plete contract with a term that would not be chosen by a majority of par-ties similarly situated to the parpar-ties to the contract in question. Ayres and Gertner argued that such a rule might be efficient in a model in which contracting parties have asymmetric information. However, Ayres and Gertner did not provide any persuasive examples of penalty default rules; their best example is the Hadley rule, but this rule is probably not a alty default rule. It turns out that there are no plausible examples of pen-alty default rules that solve the information asymmetry problem identi-fied by Ayres and Gertner. The penalty default rule is a theoretical curios-ity that has no existence in contract doctrine.
I. INTRODUCTION... 564
II. ANALYSIS... 565
A. Preliminaries... 565
B. Full Information... 567
C. Asymmetric Information Between Parties... 569
D. Asymmetric Information Between Parties and Courts... 571
E. Summary... 572
III. EMPIRICAL ANALYSIS... 573
A. Hadley ... 574
B. Zero Quantity and Legal Formalities... 575
C. Unilateral Mistake and Other Contract Formation Rules... 577
D. Interpretive Presumptions... 578
E. Section 2-210... 580
F. The Understandings of Legal Decisionmakers... 581
1. The Uniform Commercial Code... 582
2. Some Recent Cases... 582
G. Summary... 585
IV. CONCLUSION:WHY ARE THERE NO PENALTY DEFAULT RULES?... 586
I. INTRODUCTION
Ayres and Gertner’s influential article, Filling Gaps in Incom-plete Contracts: An Economic Theory of Default Rules,1 introduced
the concept of the “penalty default rule,” which is a rule that fills a gap in a contract with a term that would not be chosen by a majority of parties similarly situated. The purpose of penalty default rules, Ayres and Gertner argued, is to force parties to reveal private infor-mation, which enables their counterparts to perform more efficiently than they would if left uninformed.2
At the time Ayres and Gertner wrote their article, many law-and-economics scholars believed that default rules should reflect the preferences of a majority of similarly situated parties.3 Ayres and
Gertner showed that this view is not necessarily correct if parties have private information when they bargain with each other prior to entering a contract. If they do, and if various other assumptions hold, then penalty rather than majoritarian default rules are optimal.4
Es-tablishing this normative claim was the main purpose of their article, and it is not my goal here to quarrel with it.5
Ayres and Gertner also made a positive claim: they argued that many default rules are, in fact, penalty default rules. Their central example was the rule of Hadley v. Baxendale, a case which held that a carrier was not required to pay damages for losses that were an un-foreseeable consequence of his breach. They also cited the “zero quantity” default rule in U.C.C. section 2-201 and a handful of other doctrines.
1. Ian Ayres & Robert Gertner, Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules, 99 YALE L.J. 87 (1989).
2. Id. at 91.
3. Although, several scholars had identified the information-forcing benefits of non-majoritarian default rules such as Hadley v. Baxendale, (1854) 156 Eng. Rep. 145 (Exch. Div.), the case that was the focus of Ayres and Gertner’s article. See Ian Ayres & Robert Gertner, Strategic Contractual Inefficiency and the Optimal Choice of Legal Rules, 101 YALE L.J. 729, 735 n.24 (1992). Earlier papers with this insight include Charles J. Goetz & Robert E. Scott, Enforcing Promises: An Examination of the Basis of Contract, 89 YALE L.J. 1261, 1299-1300 (1980), and John H. Barton, The Economic Basis of Damages for Breach of Contract, 1 J.LEGAL STUD. 277 (1972).
4. A similar argument was made roughly contemporaneously by Bebchuk and Shavell.
See Lucian Ayre Bebchuk & Steven Shavell, Information and the Scope of Liability for Breach of Contract: The Rule of Hadley v. Baxendale, 7 J.L.ECON.&ORG. 284 (1991).
5. Nor do I have any disagreement with those who have used the penalty default idea to investigate similar phenomena in other areas of the law such as statutory interpre-tation, e.g., Einer Elhauge, Preference-Eliciting Statutory Default Rules, 102 COLUM. L.
However, on closer inspection, none of the examples they provide in their original or subsequent papers turn out to be a clear penalty default rule. The Hadley rule is probably not a penalty default rule and, in any event, is certainly not a clear example of one. The zero-quantity default rule is not a default rule but an element of a legal formality. The other examples in the Ayres and Gertner article are not existing legal rules at all, but proposals for legal change. Rules cited by Ayres in subsequent scholarship as examples of penalty de-fault rules are not dede-fault rules but instead are contract formation rules or interpretive presumptions. Nor have other scholars identi-fied clear examples of a penalty default rule. And, in my own re-search, I have been unable to find a clear example of a penalty de-fault rule or an example of an authoritative legal decisionmaker, such as a court or legislature endorsing a penalty default rule for reasons related to the factors identified in Ayres and Gertner’s model. All of this suggests that there is no such thing as a penalty default rule; penalty default rules simply do not exist or are not a distinctive doctrinal category.
Part II of this Article recapitulates Ayres and Gertner’s Hadley
analysis. Part III looks at the doctrine. The Conclusion speculates about why there are no penalty default rules in contract law and whether it matters.
II. ANALYSIS
A. Preliminaries
Default rules are rules that, in Ayres’ succinct formulation, “gov-ern in the absence of contrary agreement.”6 As I will discuss
pres-ently, there is confusion in the literature about what rules count as default rules and what rules belong to other categories. To clarify these issues, I will use the following framework—Imagine that a party claims breach of contract, and seeks damages. The court must (1) determine whether contract formalities are satisfied; (2) if so, de-termine whether there was real consent (not fraud, duress, mistake); (3) if so, determine what the contract says; (4) if there is a gap (that is, if the contract does not address the contingency that caused the dispute), apply a default rule; and (5) if an explicit or implied term was violated, award a remedy.
The rules that are applied at each conceptual stage have different functions and effects. In step 1, courts apply contract formation rules such as the offer/acceptance doctrines, the consideration doctrine, and the statute of frauds. In step 2, courts apply rules that determine
6. Ian Ayres, Default Rules for Incomplete Contracts, in 1 THE NEW PALGRAVE
whether the parties consented, such as rules governing fraud, duress, and mistake. In step 3, courts apply rules of interpretation, including interpretive canons and the parol evidence rule. In step 4, courts ap-ply default rules. In step 5, courts award damages or other remedies.7
Thus, the focus of this Article is step 4.
Arguably, interpretive rules are analytically the same as default rules. Often contracts have a term that can be reasonably interpreted in multiple ways. One normally says that courts resolve ambiguities by applying interpretive presumptions, but one might with equal ac-curacy say that ambiguities exist because parties fail to anticipate that the term will have more than one possible meaning, that there-fore such contracts involve a “gap” where one would otherwise find a definition that eliminates the ambiguity, and that courts fill the gap using a default rule. Although I will generally treat interpretive pre-sumptions as their own category, in Part II.D, I address the argu-ment that they are identical to default rules and conclude that even if they are default rules, they are not penalty default rules.
Because one of my arguments will be that doctrines that are fre-quently identified as default rules are not default rules at all, I want to emphasize here that I am not defining the category out of exis-tence; there are many real default rules. The obvious marker is the “unless otherwise agreed” phrase, which is almost always attached to a default rule but never to other types of rules such as legal formali-ties and contract formation rules. Here are a few random examples from the U.C.C.: “reasonable price” if the price term is left open, “best efforts” in exclusive dealing contracts unless otherwise agreed, deliv-ery in single lot unless otherwise agreed, delivdeliv-ery at seller’s place of business unless otherwise agreed, reasonable time for delivery if de-livery time left open, payment due at time and place of dede-livery unless otherwise agreed, assortment of goods is at buyer’s option unless otherwise agreed, merchant sellers warrant that goods are free of claims of third parties unless otherwise agreed, implied war-ranty of merchantability unless excluded or modified, and implied warranty of fitness unless excluded or modified.8 Indeed, virtually
every section of part 3 of article 2 contains one or more default rules. By contrast, legal formalities (step 1), such as the statute of frauds, cannot be avoided by agreement, nor can contract formation rules (step 2: offer/acceptance, fraud) or interpretation rules (step 3). In my schema, remedial rules (step 5) simply implement default
7. As is standard in the law-and-economics literature, I treat remedial rules like ex-pectation damages and the Hadley rule as a default rule (step 4); in which case step 5 should be interpreted as the court, in essence, enjoining the defendant to carry out the im-plicit term (say, expectation damages) created by a default rule in step 4, if there is no ex-plicit liquidated damages clause identified in step 3.
rules that are used to fill gaps; otherwise, they may be immutable rules (like the penalty doctrine and restrictions on injunctions). Ayres and Gertner’s model applies to step 4, the application of fault rules. They say little about step 3, the stage at which courts de-termine whether there is a gap. I will say more about this step later. For now, let us focus on default rules and Ayres and Gertner’s chief example of a penalty default rule, the rule of Hadley v. Baxendale.
B. Full Information
In Hadley v. Baxendale, a miller hired a carrier to transport a crankshaft. The carrier failed to deliver the crankshaft on time. The miller was unable to operate his mill and lost profits—that is, in-curred consequential losses. The contract itself did not have a term that said what would happen if the crankshaft was delivered late— for example, whether the carrier should pay damages equal to the miller’s losses, should refund the fee, or something else. Thus, the contract had a gap. The Hadley rule is, in essence, that the carrier does not have to pay damages for the consequential losses unless they are foreseeable or communicated in advance. However, if the parties choose, they may agree in the contract that the carrier should pay the consequential losses. Thus, the default rule is foreseeable losses, but the parties can opt out of the default—that is, fill the gap—by agreeing to liability for consequential losses at the time that they enter the contract.
To understand Ayres and Gertner’s analysis of Hadley, one can best begin with a simpler version of the example that they analyze. Sup-pose that at the time that the miller and the carrier enter their con-tract, the miller values performance at some amount, V. The valuation can be low (VL) or high (VH); let us suppose that the valuation could be either with equal probability, and E(V) is the mean of VL and VH. The carrier can deliver using normal care at low cost (CL) or using a high level of care at high cost (CH). When the valuation is high, the optimal contract provides for high care; when the valuation is low, the optimal contract provides for low care. I assume full information.
Let t refer to transaction costs, which increase with the complex-ity of the transaction. If the contract does not refer to care level, transaction costs are low; if it does, transaction costs are high.
If the default rule is that a carriage contract with a gap requires the high level of care, then the carrier will offer the simple contract to all high types. In the case of low types, the carrier must choose be-tween offering the simple contract or the complex contract—again, depending on the transaction costs and precaution inefficiencies. Assuming that the cost of transacting around is the same for low types and high types and that the inefficiency resulting from the failure to contract around is the same, then the optimal default rule will just be the rule that benefits a majority of the shippers. If most shippers are high types, then the default rule should be high precau-tion; otherwise, the default rule should be low precaution.
Note that under this reasoning the majoritarian rule is not the best rule if—for whatever reason—the transaction costs for the ma-jority type are much less than the transaction costs for the minority type. If, for example, there are five high types and four low types, but it costs high types $10 to opt out and it costs low types $20 to opt out, then the default rule should be the low-precaution rule preferred by the low types (assuming that both types prefer opting out to ineffi-cient precautions). When the default rule is minoritarian, the major-ity high types opt out at a cost of $50; when the default rule is ma-joritarian, the minority low types opt out at a cost of $80.
The Hadley rule is a slightly more complicated version of my low-precaution default rule. Rather than saying that the default is low precaution, it says that the shipper is entitled to damages that would be available to the low type. Failure to contract around the low-precaution default rule and the Hadley rule would lead to the same result: a low level of care. The only difference is that the carrier that engaged in the low level of care would pay nothing under my default rule, whereas it would have to pay a low level of damages under the
Hadley rule if the low level of precaution resulted in delay.
interpretive canons to resolve the ambiguity. Having done so, the court might decide that a gap does or does not exist.9
C. Asymmetric Information Between Parties
Suppose there is asymmetric information. The carrier does not know the type of any particular customer but does know the distribu-tion of types, and thus knows E(V). Again, optimally the carrier takes high care with high-type millers, and low care with low-type millers. But if the carrier does not know the type of miller, he will take aver-age care, which is too low for high-type millers and too high for low-type millers. Too much or too little care results in inefficiency. The inefficiency results because some parties with private information do not want to reveal it. They do not want to reveal their private infor-mation because if they do, then they will have to pay a higher price, and this cost would exceed any benefit from the better level of care, because part of the cost is externalized on other parties.
The existence of such information externalities is not a sufficient
reason to abandon majoritarian default rules. The carrier has an in-centive to discover the types of the millers and an easy way to do so. The carrier has an incentive to discover the types because, if he knows the types of millers, then he can provide optimal care and the right price for optimal care, undercutting competitors who fail to do so. The carrier’s easy way to discover the types is to offer a menu of contracts—a high-price, high-care package, and a low-price, low-care package. If the default rule is majoritarian, then the carrier can save transaction costs by offering simple contracts to the majority type (say, low), and the complex contract—which specifies level of care— for the high type. The default rule would specify low care because that is what a majority of the parties would want.
But conceivably the majoritarian default rule could be inferior to a penalty default rule. As in the full information case, one reason might be that it is sufficiently more expensive to write complex
9. One last point concerns the difference between what Ayres and Gertner called “tailored” and “untailored” defaults. To understand this distinction, note that a court might try to fill a gap with exactly the term the two parties to the dispute would have chosen if they had anticipated the dispute—in other words, the term that would have maximized the
tracts for high types than for low types. There is no reason to think this might be likely, but it is a theoretical possibility.
Another reason—the focus of Ayres and Gertner—is that the infor-mation externality is (sufficiently) higher when the minority fails to con-tract around than when the majority fails to concon-tract around. Again, there is no particular reason to think this is so, but it is possible.
However, even if these outcomes are possible, they are not plausi-ble. Real people do not divide into majority types and minority types; there is most likely a distribution of valuations best imagined as con-tinuous, perhaps a truncated normal curve or a uniform distribution or something similar. If this is what the world looks like, then the majoritarian default rule will usually favor parties with the mean valuation, or valuations close to the mean, and disfavor parties with valuations at both tails. But there is nothing about being at a tail in a distribution that would make it likely that the parties have idio-syncratically high transaction costs.
A further puzzle is why, as Ayres and Gertner seem to assume, majoritarian default rules and penalty default rules would coexist. The Hadley model is quite general and can be applied to any element of a contract—not just damages, but price, assignability, location of delivery, and so forth. There is no reason to think that information externalities pose more of a problem when parties omit a damages term than when parties omit a price or assignment term. Default rules of the kind found in the U.C.C. operate at a high level of gener-ality and are not necessarily specific to any market.10 If Ayres and
Gertner’s claim that the Hadley rule is a penalty default rule is cor-rect, then one would expect all general default rules to be penalty fault rules. If it is not correct, then one would expect all general de-fault rules to be majoritarian dede-fault rules.
In sum, penalty default rules can be efficient relative to majori-tarian default rules but only if one makes special assumptions. These assumptions strike me as implausible, but others may disagree. I have argued elsewhere that it would be difficult to show that these assumptions are valid, and I will not repeat that argument here.11
10. As Scott and Schwartz note, the default “rules” in the U.C.C. seem a lot more like general standards than rules. They argue that such vague standards do not provide guid-ance and are largely unhelpful. See Alan Schwartz & Robert E. Scott, Contract Theory and the Limits of Contract Law, 113 YALE L.J. 541, 601 (2003). I am not sure I agree with them, but the point here is that the various default rules in the U.C.C. apply to settings that seem, analytically, extremely similar, so it is hard to see why some would be penalty default rules and others would be majoritarian; given the similarity of the settings, one would expect all to belong to one type or all to belong to the other type.
D. Asymmetric Information Between Parties and Courts
Although the bulk of Ayres and Gertner’s original article provides a model of asymmetric information as between parties, they fre-quently justify penalty defaults on the basis of an entirely different theory. This theory points out that courts are expensive and fallible institutions. If a contract has a gap, the courts must lumber into ac-tion and try to determine the efficient term. But this is difficult and costly, so it would be better for parties to supply the term ex ante. To encourage parties to fill gaps at the time of contracting, courts should use penalty defaults. To avoid the bad outcomes created by penalty defaults for the majority of parties, this majority will fill gaps, thus simplifying the task for courts in most cases. By contrast, if people know that courts enforce majoritarian rules, they will feel less ur-gency about specifying terms in their contracts, knowing that the courts may do a good enough (even if not perfect) job.
There are two ideas here, and they must be carefully distin-guished. The first idea is that courts use legal doctrines to encourage contracting parties to provide sufficient detail in their contract, so that judicial interpretation in case of dispute will be guided by the ex ante intent of the parties, rather than by judicial guesswork. This idea was advanced by Lon Fuller, who argued that legal formalities serve this evidentiary function.12
The second idea is that penalty default rules (in addition to legal formalities) serve the function of encouraging parties to produce specific rather than vague contracts. Ayres and Gertner argue that penalty de-fault rules encourage specificity by penalizing parties—giving them what they would not have wanted—who agree to vague contracts.
The first idea is plausible, but the second idea—that penalty de-fault rules are the cure—is less persuasive. As to the diagnosis, there is no doubt that in a simple economic model, the parties have an in-centive to externalize their costs on courts. One way of doing so may be to leave gaps in their contracts in the expectation that courts will fill them properly in case there is a dispute.
But the obvious remedy to this problem is to charge parties a fee for using the court system. They are charged modest fees already; perhaps the fees should be higher and especially for contract cases. Another obvious remedy—noted by Ayres and Gertner—is to refuse to enforce indefinite contracts. Traditionally (though less so today), courts would refuse to enforce indefinite contracts even if they were
The Default Rule Paradigm and the Limits of Contract Law, 3 S.CAL.INTERDISC.L.J. 389, 416 (1993).
sufficiently definite to resolve the dispute in question.13 Thus, when
parties draft a contract, they will fear leaving a gap lest a court re-fuse to enforce the contract on grounds of indefiniteness—even if the gap has no bearing on the dispute before the court—so that which-ever party would benefit from nonenforcement could simply fail to perform, eliminating the value of the contract.14
There is little reason to think that penalty default rules would be a remedy to the problem of parties leaving gaps as a way of external-izing some of the cost of contracting onto courts. Penalty default rules penalize only the majority of parties for failing to fill a gap. However, the judicial externalization problem is not caused by the majority of parties; it is caused by all the parties—that is, both types, not just the majority type. By contrast, the indefiniteness rule ap-plies to all parties, just as the judicial externalization problem re-quires. So does the rule that requires parties to pay court costs. The larger point is that Ayres and Gertner’s analysis of penalty default rules—their use of the Hadley model to identify the relevant variables for determining what the optimal penalty (and/or majori-tarian) rules should be—is irrelevant to the question of how parties should be discouraged from externalizing costs on courts. The Hadley
model concerned how parties should be discouraged from concealing information from each other or, put differently, from externalizing in-formation costs on third (contracting) parties. Thus, the variables that are important in the Hadley model, such as the proportion of parties that belong to the high type or the low type, are not relevant to the analysis of how to discourage externalization of costs on courts. Thus, even if Ayres and Gertner’s analysis of Hadley is cor-rect, there is no reason to think that limiting damages to foreseeable losses would result in the optimal amount of detail in the contract from the perspective of the judicial externalization problem.
E. Summary
Ayres and Gertner’s Hadley model shows that under certain
pa-rameters optimal default rules would not maximize the ex ante value of particular contracts but would penalize parties in order to encour-age them to reveal information to each other. Drawing on Fuller’s dis-cussion of legal formalities, Ayres and Gertner also argue that optimal default rules might also penalize parties so as to encourage them to write specific and complete contracts that can be easily interpreted
13. The doctrine was overthrown by Wood v. Lucy, Lady Duff-Gordon, 118 N.E. 214 (N.Y. 1917).
and enforced by courts. “Penalizing” parties means implying terms that would not maximize the ex ante value of their contracts.
It is worth noting that what distinguishes a penalty default rule and a majoritarian default rule is not that only penalty default rules are information-forcing. Both types of rule are information-forcing. A majoritarian rule is information-forcing because the minority types will contract out of it if transaction costs are low enough, revealing both their valuations and the valuations of the majority that does not opt out. The only difference between the two rules is that more par-ties opt out of—or would prefer to opt out of—a penalty default rule than out of a majoritarian default rule, everything else held equal. Ayres and Gertner are correct that in imaginable cases greater opt-ing out is more socially valuable than less optopt-ing out, despite the pense. Indeed, in the simplest case one does not need information ex-ternalities to get this result: it is true in the very simple situation where, for whatever reason, it is extremely cheap for each member of the majority to opt out, whereas it is very expensive for each member of the minority to opt out. But it is hard to think of real-world exam-ples where such differential costs hold and to believe that this is true at the general level at which default rules operate.
If I am right that penalty default rules do not promote efficiency under plausible assumptions about the world, then it is unlikely that penalty default rules would exist.15 But everyone seems to think they
exist. Do they? I now turn to this empirical question.
III. EMPIRICAL ANALYSIS
Evaluating Ayres and Gertner’s claim that penalty default rules exist turns out to be harder than it might appear. The problem is that many contract rules are ambiguous. To simplify matters, I will distinguish three types of tests: (1) there are default rules that are clearly not majoritarian; (2) there are default rules that are clearly not majoritarian, and that can plausibly be understood to incorporate the factors (cost of contracting around, distribution of types, informa-tion externalities) identified by the Hadley model; and (3) there are default rules that are clearly not majoritarian and that have been in-terpreted, explained, or defended by legal decisionmakers in a man-ner consistent with the Hadley model. The first test is weakest; the third is strongest. The first test would be satisfied by a nonmajori-tarian rule that was not intended to force parties to reveal informa-tion but reflected other concerns, such as fairness. As an aside, one might think that a good test would be the existence of default rules that force parties to reveal information; however, as I have already
noted, because virtually all default rules force parties to reveal in-formation, this test would not distinguish penalty and majoritarian default rules.
I will argue that there are, at best, one or two cases that ambigu-ously satisfy the first test, and none that satisfies the second and third.16
A. Hadley
I start with the Hadley rule, which is Ayres and Gertner’s strong-est example—perhaps their only plausible example. Still, it is not clear that the Hadley rule is a penalty default rule. There are two other possibilities: that it is majoritarian and that it is not majori-tarian but that it does not reflect the factors in Ayres and Gertner’s model.
The usual reason for thinking that the Hadley rule is not a ma-joritarian rule is that it is counter to the notion of efficient breach. The efficient breach theory says that contract damages should equal actual loss, so that the party tempted to breach will breach only if the cost of performance exceeds the lost value to the potential victim. On this view, the majoritarian damages default rule would be actual loss, for it would save the parties the transaction costs of specifying the efficient amount of damages in case of nonperformance. Since the
Hadley rule excludes the unforeseeable portion of any loss, it is not majoritarian.
The problem with this view is that it oversimplifies the analysis of optimal damages rules. The decision to breach is just one of many de-cisions the parties may make, and if damages for actual loss ensures that this decision is made optimally, it has more ambiguous effects on the numerous other decisions that parties must make—the deci-sion whether to take precautions, to mitigate, and so forth.17
Indeed, one problem with expectation damages is that they force the breacher to provide insurance to the victim against whatever event causes the breach. It will rarely be the case that the carrier
16. Proving a negative is difficult. For present purposes, it seems sufficient to focus on examples used by Ayres and Gertner (or Ayres, in his solely authored efforts) and a few other authors, and there may be penalty default rules lurking somewhere in the common law or the U.C.C. which I miss. I also ignore several putative examples of penalty default rules which are really proposals to change existing laws into penalty default rules; e.g., the discussion of Lefkowitz and the lost-profits puzzle. See Ayres & Gertner, supra note 1, at 104-06.
will be the cheaper insurer, and indeed, we observe that modern car-riage contracts always limit liability—although the shipper may pur-chase insurance from the carrier for an extra fee. Perhaps this insur-ance is frequently purchased, but one suspects not. Carriers have no competitive advantage in the insurance market. Indeed, carrier-supplied insurance is likely in many cases to be inferior to self-insurance. If this is right, then most parties would want liability lim-ited to foreseeable loss; the Hadley rule is majoritarian.18
This conclusion is bolstered by the rule’s reference to foreseeabil-ity. The carrier will not adjust its level of care in anticipation of un-foreseeable losses—whether the term “unun-foreseeable” is taken in its literal sense or used to refer to remote contingencies—because the expected loss is either insensitive to, or only remotely related to, the level of care. Thus, within Ayres and Gertner’s Hadley model, there is no benefit—in terms of a higher level of precaution against higher losses—from holding the carrier liable for consequential losses. The losses covered by the Hadley rule are in this way the type of losses against which one might want to purchase insurance, but not the type of losses the carrier should internalize for the sake of efficient precaution. Again, there would be no reason for the parties to turn the carrier into an implicit insurance company, as would be the case if expectation damages, not limited by the Hadley rule, were the de-fault.
B. Zero Quantity and Legal Formalities
Ayres and Gertner say that the U.C.C. supplies different default rules for price and quantity.19 If the parties fail to supply a price
term, the U.C.C. says that the court should imply a “reasonable price,” which will usually be the market price at the time of deliv-ery.20 If the parties fail to supply the quantity term, the U.C.C. says
that the court should not enforce the contract.21 Ayres and Gertner
interpret this provision as a “zero-quantity default.”22 The court
im-plies that the quantity will be zero and, also, though they do not say this, that the buyer has no obligation to pay anything. For Ayres and
18. But cf. Richard A. Epstein, Beyond Foreseeability: Consequential Damages in the Law of Contract, 18 J.LEGAL STUD. 105 (1989). The ambiguity of the Hadley rule has been noted by many scholars, including Barry E. Adler, The Questionable Ascent of Hadley v. Baxendale, 51 STAN.L.REV. 1547 (1999), and Jason Scott Johnston, Strategic Bargaining and the Economic Theory of Contract Default Rules, 100 YALE L.J. 615 (1990). Ayres and
Gertner seem to agree. See Ayres & Gertner, supra note 1, at 91. 19. Ayres & Gertner, supra note 1, at 95-96.
Gertner, the price default is plausibly a majoritarian rule and the quantity default is a penalty default rule.23
The reason that the zero-quantity default is a penalty default rule, Ayres and Gertner argue, is that it is clear that most parties who enter a contract would not agree to zero quantity, which would defeat the purpose of having a contract in the first place.24 The
rea-son for zero quantity is that “it is cheaper for the parties to establish the quantity term beforehand than for the courts to determine after the fact what the parties would have wanted.”25
The problem with this argument is that the zero-quantity default is not a default rule at all; it is a legal formality.26 The U.C.C. says as
much: section 2-201 is entitled “Formal Requirements; Statute of Frauds.” The requirement that certain contracts be in writing is a classic formality, and all that the zero-quantity rule does is specify that quantity (as well as a signature and reference to goods) must be in the writing. According to the official comment, the drafters of the U.C.C. required a quantity term rather than a price term because market prices, catalogs, and price lists provide an objective way to prevent opportunism (for example, a claim by the seller that the price is higher than what the parties agreed to), whereas there is no similar objective check on claims that the asserted quantity is different from what the parties agreed to.27 By contrast, section 2-305, which is
enti-tled “Open Price Term” is located in a different part of the U.C.C., a part entitled “General Obligation and Construction of Contract.” Sec-tion 2-305 is a default rule. SecSec-tion 2-201 is not. And, as Ayres and Gertner agree,28 section 2-305 is a majoritarian default rule.29
Putting aside the drafters’ own understanding of what they were doing, we can see why section 2-201 is a legal formality by consider-ing its purpose. Like all contract formalities, the purpose of the stat-ute of frauds is to prevent people from fraudulently claiming that a contract exists.30 Formalities make such fraud more difficult by
forc-ing the fraudulent party not only to perjure himself in court but also to forge documents, which is riskier and more difficult than perjury. At the same time, formalities are not supposed to be so burdensome as to interfere with good faith contracting. Forcing parties to supply a quantity term (and, in fact, not the exact quantity, but a ceiling) would be a way of checking fraud without also inhibiting contracting
23. Id. at 95-97. 24. Id. at 96. 25. Id.
26. This was pointed out in W. David Slawson, The Futile Search for Principles for Default Rules, 3 S.CAL.INTERDISC.L.J. 29, 37 (1993).
27. U.C.C. § 2-201 cmt. 1 (2005).
28. Albeit with some qualifications. See Ayres & Gertner, supra note 1. 29. See id. at 95 n.42.
too much since parties will almost always have an idea of the quan-tity involved.
One should also observe that the logic of section 2-201, as Ayres and Gertner describe it, does not follow their model, but Fuller’s older theory.31 As they describe it, section 2-201 does not force parties
to reveal information to each other by penalizing one party if he or she does not; it forces parties to reveal information to courts by pe-nalizing both parties if they do not. Ayres and Gertner think that parties should be forced to include a quantity term because the par-ties can more easily reveal their optimal quantity to the court than the court can figure it out ex post. This might be true; but it is not re-lated to Ayres and Gertner’s model, where parties have private in-formation about their valuations vis-à-vis each other.
Legal formalities are not default rules—one cannot opt out of them or contract around them. Either one satisfies them or one does not have a contract, and they apply regardless of whether there is a gap somewhere in the contract. Default rules come into play only if formalities are satisfied and a contract exists.
C. Unilateral Mistake and Other Contract Formation Rules
Ayres and Gertner have invoked formation doctrines as examples of default rules. Consider this passage from a recent article:
For example, section 153 of the Restatement (Second) of Contracts allows a contractor who is unilaterally mistaken about a basic as-sumption to void a contract if “the other party had reason to know of the mistake.” The default possibility of voidability is a penalty that the informed contractor can only avoid by revealing informa-tion. Indeed, in a Hadley-like fact pattern, a carrier could argue that a basic assumption of its promise to perform or pay damages was the belief that the miller would only have foreseeably low damages. Any evidence that the miller knew that it had high dam-ages, but failed to correct the carrier’s mistaken assumption, might be grounds for voiding the carrier’s duty to pay damages at all. A slightly expanded reading of the common law of mistake thus can be seen as a penalty default to induce knowledgeable contractors to correct the other side’s mistakes of law or fact.32
This is a puzzling argument. The mistake doctrine is not normally thought of as a default rule because it does not fill a gap in an other-wise valid contract; it results in the avoidance of the contract. In a classic mistake case, a contractor’s bid is much lower than the bids of competing contractors. The bid reflects a mistaken calculation, and
31. See Fuller, supra note 12.
the party taking the bid has reason to know that the contractor’s low bid results from a mistake. If the offeree accepts the bid, the result-ing contract would not have a gap—the price term is filled in. The problem with the contract is not that it lacks a price or has any other gap; it is that the price is “wrong.” The mistake doctrine does not fill a gap in an incomplete contract; it operates on precontractual behav-ior, preventing the formation of a contract in the first place.33
In this way, the mistake doctrine is like doctrines against fraud as well and, indeed, like legal formalities, which require parties to re-veal to each other whether they want the agreement to be legally en-forceable. None of these doctrines force parties to reveal the type of information analyzed in Ayres and Gertner’s Hadley model—that is, the value that the promisee attaches to performance and the cost of performance for the promisor. Indeed, the unilateral mistake doc-trine forces the promisee to reveal information to the promisor about the promisor’s cost, not the promisee’s valuation.
But suppose that the mistake doctrine is thought of as a default rule along the following lines. The contract does not have a term specifying the parties’ obligations if the contractor’s bid is based on a clerical error; courts apply a default rule that says that the parties have no obligations if such is the case. In other words, the default rule provides a certain term if a precontractual contingency—the clerical mistake—is not mentioned in the contract. It is worth em-phasizing that it is not clear that this is an accurate statement be-cause it is not clear that parties could contract out of this rule, but let us suppose that this is the case. Still, the mistake doctrine would surely be a majoritarian default rule, if it is a default rule at all. Given that clerical errors are difficult to avoid, that the party that receives the bid can easily detect a major clerical error by comparing the bidder’s price with the prices offered by other bidders and that the recipient of the bid need not rely on the bid given that other bids are submitted, it would make sense for the parties to agree in ad-vance on a term that relieves the bidder of its obligation if a clerical error results in a price that is substantially higher than the next highest price.
D. Interpretive Presumptions
Another kind of rule is the interpretive presumption, like the con-tra proferentem rule that a contract should be construed against its drafter. Ayres claims that this rule is a penalty default.34 Is it?
33. RESTATEMENT (SECOND) OF CONTRACTS § 153(b) (2005).
An initial but probably unimportant problem with the view that it is a penalty default is that the rule applies, at least formally, regard-less of whether there is a gap in the contract. Interpretive presump-tions operate at step 3, when the court must interpret the contract. Only if the court, applying interpretive rules, finds a gap at step 3, would it then move on to step 4 and fill the gap.
As an illustration, suppose that a contract involving a European party and an American party lists a price of “100” but does not say whether the price is in euros or in dollars. A court would (at step 3) re-solve this ambiguity. It might apply the contra proferentem rule, the parol evidence rule, or something else. Once the ambiguity is resolved in one way or another, the court’s inquiry ends. There is no gap, as there would be if the parties had not stated the price in the contract. Or as another illustration, suppose that a contract has an am-biguous statement about whether the promisee can assign the con-tract. At step 3, the court might interpret the ambiguous statement as an explicit term that forbids or permits assignment, or it might in-terpret the ambiguous statement as meaningless or inapplicable (for example, parol evidence reveals that it applied to other kinds of as-signment than the one in question in the dispute). In the latter case, the court finds a gap at step 3, so it can move on to step 4 and fill it in using the U.C.C.’s default rule which permits assignability.35
Nonetheless, one might plausibly argue that interpretive pre-sumptions are analytically the same as default rules even if they are placed in a separate doctrinal category. An ambiguous term might be reinterpreted as a term that does not fully specify obligations. In the first illustration, one might say that the price term is ambiguous be-cause the contract contains a gap—it does not say whether the price is denominated in euros or dollars. The court fills this gap by using a default rule that provides for the term that would benefit the party that did not draft the contract.
Even if this interpretation is correct, it does not establish that in-terpretive presumptions like contra proferentem are penalty default rules. In any specific application of the rule, the term chosen by the court may or may not reflect the interests of the majority of the par-ties. In the first illustration, there is no reason to think that a major-ity of American-European contract parties would prefer the price to be in euros rather than dollars. Nor is there any reason to think that the term contrary to the drafter’s interests is the term that a minor-ity (or majorminor-ity) of contract parties would choose.
When we think again of Ayres and Gertner’s model, their assump-tion was that (say) the buyer may belong to different types: a
ity type and a minority type. Now, stipulate that the sellers are iden-tical. In this setting, a penalty default rule would provide the term preferred by the minority type. The contra proferentem rule provides the term preferred by the nondrafter. In Ayres and Gertner’s setup, the contra proferentem rule would be a penalty default rule with the functions they assign to penalty defaults only if the majority type happens to be the party that drafts the contract. But there is no rea-son to believe this; more likely, the seller drafts the contract or the buyer (of either type) drafts the contract.36 Thus, the rule does not
differentiate between types, as envisioned by the Ayres and Gertner model, so the rule does not cause one type to opt out while saving the other type transaction costs. There is a mismatch between the model and the function of the interpretive presumption.
Further, if we must think of interpretive presumptions as default rules, then surely they are majoritarian. The drafter has an advan-tage: she can sneak in favorable language. But as a consequence, the drafter may have trouble persuading the nondrafter to consent to a contract. A natural solution to this problem is to agree that ambigui-ties will be construed against the drafter. Similarly, sellers may have trouble persuading consumers to agree to contracts for complex products that they do not understand unless the consumers are as-sured that ambiguities will be construed against the sellers. It is hard to imagine parties agreeing to the contrary rule—that ambigui-ties will be resolved in favor of the drafter and against consumers and insureds.
None of this is to deny that interpretive presumptions like contra proferentem have information-forcing effects. As I have noted, ma-joritarian as well as penalty default rules have these effects. The con-tra proferentem rule, for example, might encourage the drafter to be more explicit and to provide more details about obligations. This may reduce the chance that the other party will misunderstand the con-tract; it also may facilitate judicial interpretation of the contract. In-terpretive presumptions that favor consumers and insureds encour-age sellers and insurers to draft detailed and explicit contracts, which increases the chances that the less sophisticated party will understand her contractual obligations. But these effects are not the subject of Ayres and Gertner’s model.
E. Section 2-210
Ayres and Gertner cite section 2-210 in a discussion of penalty de-fault rules, though it is not clear whether they claim it is an example of a penalty default rule or not.37 Nonetheless, I will discuss it, if only
to show that the majoritarian interpretation of this rule and rules like it is more straightforward and plausible than the alternative in-terpretations.
Section 2-210(2)(a) says that a “party may perform [his] dut[y] through a delegate unless otherwise agreed or unless the other party has a substantial interest in having [his] original promisor perform or control the acts required by the contract.”38 The default thus has
two parts: (1) delegation permitted if the identity of the original pro-misor does not matter and (2) delegation not permitted if the identity of the original promisor does matter. As is always the case with a de-fault rule, the parties can opt out and prohibit delegation in the first case, or permit it in the second.
The majoritarian explanation for this rule is simple and intuitive. For the promisor, the power to delegate has value, and thus he or she will normally want to have it. This power is valuable because it al-lows the promisor to pay someone else to perform on his behalf, which he will want to do if he can find someone else who will do it for a low price or if he finds some better opportunity that conflicts with his initial promise. But delegation is undesirable for the promisee if the value of performance turns heavily on the unique abilities of the promisor and a normal damages remedy cannot fully compensate the promisee for the shortfall. Thus, one would normally expect delega-tion to be permitted when the performance is fungible and not when the promisee cares about the identify of the promisor.
Ayres and Gertner note that this rule may force a promisee to re-veal the extent to which he values the promisor’s performance, which is information the promisor may use to extract a higher price.39 To
avoid paying the higher price, the promisee might refuse to reveal his interest and, thus, consent to an inefficient contract that permits delegation.40 But it is not clear what follows from this observation.
Perhaps Ayres and Gertner’s point is that section 2-210 is not a pen-alty rule, and for this reason may be objectionable. If so, then clearly section 2-210 must count as a majoritarian rule.
F. The Understandings of Legal Decisionmakers
I have said little about step 3, which asks whether the reasoning of legal decisionmakers reflects the considerations modeled by Ayres and Gertner. One way to apply this test is to look at the reasoning given by decisionmakers rather than at the doctrines themselves.
38. U.C.C. § 2-210(2)(a) (2005).
1. The Uniform Commercial Code
The U.C.C., which is the source of many of Ayres and Gertner’s examples, was designed by its guiding light, Karl Llewellyn, to re-flect existing business norms and customs.41 Llewellyn believed that
the common law depended too heavily on formal doctrinal distinc-tions that did not match business practice and, thus, forced parties to engage in unnecessary rituals to ensure that their agreements were enforced properly.42 In addition it forced courts to engage in needless
gyrations in order to extract correct results from recalcitrant doc-trine. Llewellyn thus used business practice as a guide, and either made the U.C.C.’s default rules reflect practice or else incorporated vague standards that would allow courts to do this ex post.43
This being so, it would be surprising if the U.C.C.’s default rules re-flected nonmajoritarian preferences. They would, only if business norms and customs themselves cured the information asymmetries identified by Ayres and Gertner’s Hadley model. But this seems im-plausible. Business practices become norms because, as the term sug-gests, they are normal—most people engage in them. Most people en-gage in them because they are jointly profit-maximizing. This is the standard majoritarian approach to default rules. The opposite view would hold that two parties to a contract engage in some practice in order to benefit a third party—and this behavior becomes routinized.
2. Some Recent Cases
Seven cases contain citations to Ayres and Gertner’s original article,
Filling Gaps in Incomplete Contracts. Four of these citations are not relevant to the current discussion,44 but three of them are interesting.
Harnischfeger Corporation v. Harbor Insurance Company45
in-volved a dispute over the meaning of a clause in an excess insurance policy. The insured argued that the excess insurer’s liability would kick in when the insured (which self-insured for the primary amount) had paid out $3,000,000 in claims and legal fees.46 The insurer
ar-gued that its liability kicked in only after the insured had paid out
41. Gregory E. Maggs, Karl Llewellyn’s Fading Imprint on the Jurisprudence of the Uniform Commercial Code, 71 U.COLO.L.REV. 541, 546-47 (2000).
42. Id.
43. Id. at 553.
44. See Am. Airlines, Inc. v. Wolens, 513 U.S. 219 (1995); Coronet Ins. Co. v. GACC Holding Co., No. 90C07129, 1991 WL 172182 (N.D. Ill. Aug. 30, 1991). Another case—
Moreau v. Harris County, 158 F.3d 241 (5th Cir. 1998)—confuses contract law and statu-tory interpretation, holding that its interpretation of the Fair Labor Standards Act reflects a contract default rule. In Duncan v. Theratx, Inc., 775 A.2d 1019, 1021-22 & n.4 (Del. 2001), the court uses the majoritarian approach, only noting the possibility of penalty de-faults in a footnote.
$3,000,000 in claims only.47 The court held that the clause
unambi-guously favored the insurer’s interpretation and thus rejected the in-sured’s invocation of the principle that ambiguities should be re-solved against insurers.48 The court noted in passing, “Perhaps the
interpretive principle [that ambiguities should be resolved against insurers] could be recast as one requiring the insurer to come forth with information in its possession but unknown to the insured,” cit-ing the Ayres and Gertner article.49 But then it said, “Wisconsin has
not suggested this understanding of its approach, perhaps because it doubts judicial ability to determine how much information is optimal . . . .”50 Thus, the court rejected the penalty default analysis.
American National Fire Insurance Company v. Kenealy51 was
an-other insurance dispute. The insurer had provided in a policy that changes in coverage of the insurance (for a yacht) were valid only if approved by the insurer.52 When the insureds sought to increase the
geographic coverage of the insurance policy, the broker obtained this expansion but told them that the expanded coverage would continue for one year when in fact the insurer authorized the expansion for only a few months.53 The yacht sank after the expiration of the new
coverage but before the one-year period expired.54 The insurer sought
to avoid liability on the basis of the clause limiting coverage changes, but the court held in favor of the insureds because the broker was a proper agent with apparent authority to bind the insurer.55
The court rejected the insurer’s argument because the clause that conditioned changes on approval by the insurer did not say that the insurer could not provide such approval through its agents.56 Thus,
the contract was silent on the issue of whether an agent could bind the insurer, and the question for the court was whether the default rule should put the burden on the insurer or the insured. The court noted that in some cases the insurer is in a better position to monitor the agent, and in other cases the insured is in a better position.57 It
decided that the default should favor the insured—that is, the agent binds the insurer unless otherwise agreed—because otherwise insur-ers may “strategically withhold[] information as to what authority
47. Id.
48. Id. at 976. 49. Id.
50. Id.
51. 72 F.3d 264 (2d Cir. 1995). 52. Id. at 266.
53. Id.
54. Id.
the agent actually has, and whether the company is bound if an acci-dent occurs.”58
Although the court cited Ayres and Gertner’s article,59 the court
did not have any concerns about the insurer having private informa-tion about its valuainforma-tion. The court apparently thought that insureds would assume that the broker could bind the agent even if the law were otherwise. In effect, the court was aligning the law with the un-informed expectations of insureds—perhaps because it believed that the insurer, by using the broker in the first place, was in part re-sponsible for generating these expectations. It feared that if the de-fault rule placed the burden on the insured, the insured would not realize that the broker’s statements were not binding until ratified by the insurer and, further, that the insurer would have no incentive to clarify the law in the contract.60 Whatever one thinks of this
rea-soning, it reflects traditional consumer protection ideas and is not an application of the Ayres and Gertner model.
Finally, in City ofBurlington v. Indemnity Insurance Co. of North America,61 the court had to decide whether an “all risk” insurance
policy provided coverage only for damage caused by external events (such as storms) and not by “intrinsic” factors such as structural de-fects in the property in question. Although it certified this question to a state supreme court rather than deciding it, the court argued in passing that a default rule that all risk policies covered intrinsic as well as extrinsic losses would be a penalty default rule.
On this account, expanded coverage to the detriment of insurers in all-risk policies is justified since such expansions give insurers, who presumably have better knowledge of insurance laws than do insureds, a powerful incentive to insert explicit language into poli-cies, thereby informing the insureds as to the precise scope of cov-erage.62
Although the court cited the Ayres and Gertner article,63 like the Kenealy court, it relied on a different theory—namely, that insureds do not understand their coverage, and that default rules should re-flect the expectations of the insureds rather than the jointly optimal terms.
It should also be noted that the court does not explain why a de-fault rule that stipulated expanded coverage would not be the majori-tarian default. On the one hand, insurers might be reluctant to cover
58. Id. at 269. 59. Id. at 269 n.1. 60. See id. at 269.
61. 332 F.3d 38 (2d Cir. 2003). 62. Id. at 49.
intrinsic defects because of fears of moral hazard. On the other hand, insureds are unlikely to distinguish externally and internally caused losses—a loss is a loss—and be willing to pay for both. Indeed, the distinction between external and intrinsic losses is at best a rough and ready one: when a storm damages a structure, is the cause of the loss the “external” storm or the “internal” design problems that ren-dered the structure unable to withstand the storm? Without knowing more about the market, one cannot say with any confidence that one version of the default rule or the other is majoritarian. But given that the Burlington court does not refer to private valuations, differ-ential transaction costs by type, the proportion of types, and so forth, it could not have been applying the Ayres-Gertner model.
G. Summary
My survey of the law revealed no unambiguous penalty default rule in American contract law.64 One might argue that many of the
ambiguous default rules are actually penalty default rules—that is, they reflect the preferences of a minority rather than of a majority. But it is clear that the self-understanding of courts is otherwise: courts almost always think of themselves as choosing the rule that a majority would want. In addition, courts never take into account fac-tors relevant to the Ayres-Gertner model. Indeed, they rarely discuss the problem of private information that is identified by that model— that individuals with high valuations will try to hide this informa-tion—in the context of choosing or justifying default rules. Thus, if some default rules are not majoritarian, the most likely explana-tion—putting aside the consumer protection defaults mentioned be-low—is that courts or the drafters of the U.C.C. simply made a mis-take about what the majority prefers.
Problems of private information appear in judicial discussions mainly in cases involving consumer protection. Here, courts worry that consumers (or insureds) do not understand the law, do not un-derstand the terms of the contract that they sign, or do not properly value the product that they purchase. A few default rules seem to be intended to give the seller an incentive to explain the law to the con-sumer, or to provide explicit terms in the contract, but the justifica-tion is mainly the tradijustifica-tional consumer protecjustifica-tion justificajustifica-tion, ac-cording to which consumers are easily manipulated by sellers, not the Ayres-Gertner concern with information externalities that arise
64. Nor in British law, apparently. See KIM LEWISON, THE INTERPRETATION OF
because contracting parties can be classified into heterogeneous types who attach different valuations to the same product or service. The rules of contract law that are most explicitly concerned with information asymmetries are not default rules but interpretive pre-sumptions, contract formation rules, and—what we have not dis-cussed so far—immutable rules such as the unconscionability doc-trine. All of these rules apply regardless of whether there are gaps, no doubt reflecting courts’ concern that consumers may fail to under-stand the transaction even when the contract is detailed, explicit, and (relatively) complete.65
In sum, two conclusions are worth highlighting. First, there are no penalty default rules. Second, rules that seem designed to smoke out private information—such as legal formalities, contract forma-tion rules, and so forth—do not reflect the logic of Ayres and Gert-ner’s Hadley model.
IV. CONCLUSION:WHY ARE THERE NO PENALTY DEFAULT RULES?
Let me conclude with some speculation about why penalty default rules do not exist. But initially, let me exclude one possibility—that the Ayres and Gertner model is in fact wrong. The model and their general point are correct: within the confines of the model’s assump-tions, there may be good reasons for penalty default rules. The ques-tion, then, is why courts and legislatures have not endorsed this rea-soning and created penalty default rules.
One possible reason is that the Ayres-Gertner model has not yet been absorbed into contract theory, but at some future point, after the ideas have been taught to enough generations of students, the ideas will become a part of the general understanding of contract law. Although one cannot know what the future holds, the early judi-cial response suggests that this will not happen. Indeed, this re-sponse suggests that the problem with the Ayres-Gertner analysis is that it is too complicated and indeterminate for judges to use.
Alan Schwartz and Robert Scott have made a similar but more general argument about default rules.66 They argue that courts do
not create default “rules” that are specific enough to have value for the parties because the parties have adequate incentives for supply-ing optimal terms, even with asymmetric information, where signal-ing and screensignal-ing mechanisms can be used which, if not perfect, are
65. Indeed, the kind of asymmetric information model used by Ayres and Gertner does not rely on contractual gaps; it could justify the refusal to enforce explicit terms. See
Philippe Aghion & Benjamin Hermalin, Legal Restrictions on Private Contracts Can En-hance Efficiency, 6 J.L.ECON.&ORG. 381 (1990).
better than anything that courts could produce.67 Although the
U.C.C. and the common law contain many default “standards,” these standards are too vague to provide guidance for parties or courts. If Schwartz and Scott are right that courts do not bother producing de-fault rules and tend to enforce the terms that the parties supply and no more, then it would follow a fortiori that there are no penalty de-fault rules.
A final reason that penalty default rules do not exist may be that contract law doctrine is not well suited for the types of information externalities identified by Ayres and Gertner’s model. Contract doc-trine is extremely general; it applies in diverse market settings. In-formation externalities may be much more of a problem in some markets—say, insurance markets—than others, and the appropriate response may be ex ante regulations oriented to a particular market rather than general contract law. For example, insurance markets are thought to be especially vulnerable to information externalities, and here we have massive ex ante regulation, including price, term, and market access regulation. Courts may feel that they should allow legislatures to identify information externalities and enact appropri-ate laws, and that neither common law development nor general commercial codes are appropriate for such problems.
Indeed, common law courts have been remarkably passive about solving contract externalities. Prior to the enactment of antitrust leg-islation, courts only occasionally interfered with restraints on trade. Occasionally citing public policy, courts strike down contracts that are not themselves illegal but might further illegal conduct, but here legislation comes first and identifies the illegal conduct. Contract for-malities protect third parties from fraudulent claims that they have entered contracts. And tort rules like the fraud doctrine prevent the most obvious kind of externalizing behavior. Otherwise, contract doc-trines tend to enforce freedom of contract; most mandatory rules are paternalistic or otherwise inexplicable from a conventional economic perspective. Ayres and Gertner’s argument implicitly assumes that courts would use general doctrines of contract law in order to deter parties from producing subtle information externalities that were first identified by economists only thirty years ago. It is more likely that the century-old Hadley doctrine, like other doctrines of contract law, reflect judicial conjectures about the hypothetical bargain—the jointly value-maximizing terms that most parties would want.
